Outsourcing Risk Management

 

1. Understand the project- Companies that choose to outsource applications must have a high degree of understanding of the project they are undertaking, including its requirements, the method of its implementation and the source of expected economic benefits. This is crucial to providing reasonable incentives for meaningful measures of performance. On Wall Street, historically, attention and rewards have been given to those who produce profits, like successful trading desks; there has been less interest in managing cost centers like information processing. Despite the strategic importance of information infrastructure, many companies on the Street have attempted to squeeze systems, and they have failed to provide the resources or the guidance needed for long-term investment in IT. When they realized that they have not always done a good job managing this area or rewarding performance, some have outsourced with contracts obligating vendors to “do a better job”; however, this provides neither the metrics needed to define a better job nor the incentives for the vendor to steer in the desired direction. Understanding project objectives also helps to reduce the risks of poaching, since it is then possible to specify and control access to elements that may be critical to the client’s future competitive positioning. The risks of outsourcing product distribution-as airlines did with computer reservation systems in the 1970s, for example-can clearly shift too much power to the distribution system. Using a third-party information processor to manage client relationships can allow another party to have access to your customer history and pick off your best accounts. The most successful projects we studied were those in which the client was fully capable of developing the application itself but chose to outsource simply because of constraints on time or staff availability.

 

2. Divide and conquer- Dividing a large project into smaller, more manageable pieces will greatly reduce programmatic risk. In principle, completion of each independent chunk creates the possibility that subsequent development work will be handed off to a different developer. Each chunk should have specific objectives and quality metrics, and each piece should be independent, in the sense that companies would have to absorb only tolerable increases in development costs should they choose to switch vendors after one or more chunks has been completed. Although this will increase development costs, it reduces or eliminates the risk of vendor holdup. If the vendor attempts to overcharge for continuation, the self-contained nature of the work completed to date will permit a more or less painless handoff to another vendor for continuation of development. Moreover, by assessing checkpoints at the completion of each chunk, the company can detect quality problems and reduce the risk of shirking or underperformance. Thus, when deciding on the milestones for such a project, it is important to have a viable exit strategy if any chunk fails.

 

 3. Align incentives- Although the vendor’s incentives can never be fully aligned with those of the client, it is frequently possible to design contractual incentives that will help enhance performance. If you pay a telephone interviewer for the number of calls he makes, they will be short; if you pay for the number of minutes he is on the phone, each call will be long; if you pay for applications approved, you will have lots of approvals, and if you pay for applications rejected, you will have lots of rejections. What you want to do is pay for incremental sales. Unfortunately, such incentives are not always guaranteed to work. It is difficult to define incremental sales or determine the basis of compensation for your call center operators. A similar “law of the wallet” holds in all software outsourcing, and it suggests that you get what you pay for: If you pay for lines of code, for example, you will get many lines of code; if you pay for testing, you will get lengthy test logs. Incentives can bring vendor behavior in line with a client’s expectations, thereby improving performance, but they can also distort it, causing performance to drop. It depends on how well individual vendor activities can be measured and how accurately measurable and rewardable activities can be correlated with desired performance. In short, for all its attractiveness, there are a number of potential costs and risks associated with outsourcing. The above guidelines can help keep those risks under control. One final tip: When in doubt, hiring an honorable and well-managed vendor with a reputation to preserve may be your best protection.